Adding emerging markets (EM) to a portfolio has its benefits: the potential for high growth as well as adding balance by including investments from up-and-coming economies around the world. But emerging markets investments also come with inherent risks that other asset classes aren’t subject to. In this case, it may be wise to consider active strategies over their passive counterparts.
Active and Passive Happily Coexist
Both active and passive strategies can rise to the top out of the investment universe in the decision-making process. Both are tools to consider and can complement one another in a portfolio. However, when risks are higher, we believe actively managed portfolios offer the oversight and risk management that emerging markets investing should demand.
More Risk, More Oversight Needed
Below are four reasons an active approach to emerging markets may have an edge over a passive approach—it comes down to oversight.
1. More Inefficiencies
Emerging markets remain significantly less efficient than developed markets because of reporting and transparency gaps. Considerably fewer financial analysts cover emerging markets, and many EM firms aren’t reported on at all. EM companies also have lower levels of reporting disclosure, less access to management, and they can fall victim to language and cultural barriers. This leads to a greater dispersion of earnings estimates, a higher likelihood of earnings revisions and surprises, as well as a wider range of performance results.
The dispersion in performance could result in significant opportunity cost—loss of potential gains—by taking a passive approach. Active managers who use a bottom-up, fundamentals approach can provide insight into a company’s financials and its overall stability, uncovering information that might otherwise be missed.
2. Greater Volatility
Emerging markets stocks have historically experienced more volatility and a significantly greater range of returns among all EM funds and compared to their benchmark indices. They also show more volatility compared to developed markets.
Active managers have the flexibility to take advantage of this situation and avoid certain companies in an index, or choose companies outside the index, to include in their strategies.
3. Less Movement in Tandem
More than any other asset class, EM stocks tend to get generalized. Many investors believe that shifting economic conditions (e.g., U.S. dollar moves, product price fluctuations, trade disruptions) affect all countries and companies in a region the same. Actually, EM companies are more affected by local economic conditions and less by global macroeconomic trends, historically generating approximately two-thirds of their revenues locally.
Active oversight and fundamental research can help identify countries and companies that are moving against regional trends and find opportunities that passive indices cannot.
4. Possible overexposure
Emerging markets large-cap indices are dominated by the largest and most prominent companies from the largest countries in a region. Index investing can increase concentration risk with a small number of firms and further expose investors to well-known companies that they may already be exposed to in their portfolios. This reduces diversification benefits because they may react to global macroeconomic trends more like a developed markets firm than one that’s EM-focused.
Portfolio managers can employ active risk management to selectively increase, decrease, or even avoid altogether, exposure to big names as market opportunities shift.
Oversight Can Justify Costs
Driven by the belief that low-cost, index-duplicating investments deliver more value in the most efficient markets, the significant shift from active to passive has been great. While active and passive both have their place in a portfolio, emerging markets’ inherent inefficiencies may give active approaches the edge. When risks are higher, investors can benefit from active managers’ bottom-up, fundamental research and their consistent application of investment philosophies and processes.
In the end, the additional costs of an emerging markets actively managed strategy may actually provide the most value.
Get more information about investing in active emerging markets strategies.
International investing involves special risks, such as political instability and currency fluctuations. Investing in emerging markets may accentuate these risks.
Diversification does not assure a profit nor does it protect against loss of principal.
The opinions expressed are those of Nathan Chaudoin and are no guarantee of the future performance of any American Century Investments fund. This information is for educational purposes only and is not intended as investment advice.